Will 'Junk' Munis Bite Back?

By

Ben Levisohn

Updated June 15, 2012 6:51 p.m. ET

Are you taking too much risk with municipal bonds?

Investors have poured about $24 billion so far this year into muni bonds, on pace for the most since 2009. But about 22% of that is going into riskier high-yield, or "junk," bonds—those rated below triple-B by Fitch Ratings and Standard & Poor's, or Baa by Moody's Investors Service. That is up from 17% of inflows as recently as 2010.

ENLARGE

The Scranton, Pa., Parking Authority missed a debt payment.
Alamy

The lure: High-yield munis are yielding about 5.2%, versus the measly 2% offered by their investment-grade counterparts. Muni-bond yields are generally exempt from federal and state income taxes.

Yet some experts are alarmed by the trend and advise investors to start moving back into higher-quality municipals.

They worry that the sluggish U.S. economy could put additional stress on municipal finances and that states could continue to cut funding to local governments. That could send investors rushing back into higher-quality bonds and cause the prices of the riskiest munis to plummet.

Investors aren't getting enough yield to cover that risk, says
Chris Mauro,
head of U.S. municipal-strategy research at RBC Capital Markets.

Most bond yields have fallen recently, from munis and Treasurys to corporate bonds. A top-rated 10-year municipal bond now yields just 1.91%, down from 4.07% a decade ago.

At the same time, municipalities have been refinancing their older bonds at record levels. Through the end of May, 63% of new bonds have been issued in order to pay off older ones, on pace for the highest proportion since the Securities Industry and Financial Markets Association began keeping track in 1996.

ENLARGE

Those refinancings put investors in a tight spot. Say a municipality was refinancing a triple-A-rated bond an investor bought three years ago with a yield of 3.37%. To get the same yield, an investor would have to buy a lower-rated bond, such as a 15-year double-A-rated bond or a triple-B-rated bond maturing in eight years.

Because bond prices and yields move in opposite directions, the extra yield an investor gets from the former is falling. For example, the difference between the average yield on a triple-B-rated municipal bond in the Bank of America Merrill Lynch municipal-bond index—the low end of investment grade—and a triple-A-rated one has dropped to just 2.64 percentage points, the smallest since 2010.

That narrowing has experts concerned that the rally in riskier munis may be nearing an end. "We're concerned that the cycle may be on its last legs," says
Bart Mosley,
co-president of Trident Municipal Research in New York. "There's still time to take profits and move back into higher-quality bonds."

There is a good chance high-yield munis are going to get riskier as the sluggish U.S. economy takes its toll on municipal finances, RBC's Mr. Mauro says. Total state gross domestic product grew at a 1.5% clip in 2011, less than half the 3.1% rate in 2010, a sign that momentum may be waning. At the same time, states are increasingly closing their budget gaps at the expense of localities.

On May 22, for instance, Maryland approved a budget that shifted the cost of funding teacher pensions from the state to municipalities, saving it more than $100 million in fiscal 2013, according to Moody's. Yet the move will put additional pressure on counties in the state. Other states, including Illinois and Florida, also have looked for ways to limit the money being sent to local municipalities.

"When states need to balance their budgets, they look to cut the funding heading to local governments," says
Naomi Richman,
a managing director at Moody's. "Until the economy has a robust recovery, you'll see this continue."

Defaults remain rare. But the battle over funding could lead to downgrades and more missed payments.

Detroit came within days of default this past week because of a disagreement between the city and Michigan authorities over bailout payments—a situation that spurred Fitch to cut Detroit's rating from single-B to triple-C on June 12. On Thursday, Moody's downgraded all California "tax allocation" bonds—a riskier sector of the market—to junk status.

On June 1, meanwhile, the Scranton, Pa., Parking Authority missed a payment on its debt after the city council declined to make up a shortfall. On Thursday, the council decided to make good on its guarantee, reversing the default.

Investors should be especially wary of lower-rated bonds, especially those that back ancillary projects, such as dormitories, development agencies and hospitals, says
Richard Ciccarone,
chief research officer at McDonnell Investment Management in Oak Brook, Ill., which manages nearly $15 billion.

Instead, they should consider investing in higher-rated general-obligation bonds—those rated at least double-A—which are backed by the full taxing power of a state, city or county, and bonds issued by essential services like water and sewers, Mr. Ciccarone says.

"The weak are getting weaker," he says. "This is a great time for an upgrade."

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